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Under federal tax laws, taxpayers are allowed to borrow money from 401(k) plans and these funds can be used for any legal purpose. Some people view retirement plan loans as the borrowing option of last resort but despite the psychological impact of drawing on one’s pension pot, 401(k) loans provide many borrowers with an inexpensive and easy to obtain loan option.

Plan participants can only obtain 401(k) loans if their employer’s retirement plan includes a loan option. The Internal Revenue service permits pension plan loans but does not require 401(k) sponsors to include loan provisions in these plans. Since 401(k) loans do not impact the plan sponsor’s bottom line, many plans include a loan provision. Additionally, 401(k) loans are easier to obtain than other types of loans since credit checks do not typically form part of the application process.

Generally, 401(k) plans are funded with employer contributions and employee elective salary deferrals. Retirement plans are subject to vesting schedules and vesting describes the process during which contributed funds become the property of the plan participant. Elective deferrals and earnings are immediately vested but in some instances employer contributions become vested over the course of six years. Vesting schedules are significant in terms of 401(k) loans because a plan participant can borrow the lesser of $50,000 or 50 percent of the vested balance of their account.

An employee can borrow money from a 401(k) in the form of a single loan or a series of loans. Loan terms can last for as long as five years and the loans are repaid with salary deductions. Significantly, 401(k) loans are normally funded with gross earnings while repayments are made with net earnings. Since 401(k) withdrawals are fully taxable this means that the borrower ends up paying income tax on the money prior to making a loan payment and again when the funds are eventually withdrawn from the account.

Interest rates on 401(k) loans are normally based upon the Wall Street Journal’s prime rate which reflects the average cost of borrowing for creditworthy clients at the nation’s leading banks. Home equity loan rates are also normally based upon prime rate. However, interest payments on an equity loan are paid to the bank whereas interest payments on a 401(k) loan are applied to the borrower’s own pension plan. This means that borrowers effectively pay themselves interest.

Retirement plan loans have to be repaid in full if the borrower stops working for the plan sponsor. In the event that the borrower fails to repay the loan, the loan is re-characterized as a pension plan withdrawal. The borrower has to pay ordinary income tax on the money and possibly state income tax. Furthermore, withdrawals from pension plans by people below the age of 59 ½ are usually subject to a 10 percent tax penalty.

People who take out 401(k) loans do not have to pay interest to lenders which means that these loans are a low cost alternative when compared with credit cards, personal loans and mortgage products. If the borrower remains employed for the duration of the loan term then the taxes are not a factor. However, job losses are not always foreseeable which means that anyone who takes out a 401(k) loan is taking a calculated risk.

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